Every spring, a company's shareholder prospectus uncovers the glut of salary and stock options enjoyed by top corporate officers. There has been suspicion, though little hard evidence, that managers may actively try to boost the value of their options before the yare awarded. But recent research by Stanford GSB faculty member Ron Kasznik reveals that some top executives do indeed manage the timing of key company announcements, such as earnings projections, to increase the worth of their awards.
Working with David Aboody, assistant professor of accounting at UCLA's Anderson Graduate School of Management, Kasznik has examined how compensation incentives affect executives' decisions to disclose information. Using data from 572 firms that awarded options on almost the same dates year rafter year, the researchers looked at the compensation for each firm's chief executive officer over a five-year period ending in 1996. In their examination of 2,039 scheduled CEO stock option awards, they discovered that the pattern of stock price movements, analyst forecast revisions, and management earnings forecasts around the time of the awards is significantly different from the pattern observed for these firms at other times. "This may be the first time a link has been shown between CEOs' and other top managers' compensation and the decision to voluntarily disclose information," Salsas, who is an assistant professor of accounting.
The researchers noticed that stock price increases occurred after, rather than before, the option award dates. "We also found that before the award date they were more likely to disclose bad news and they tended to wait with good news until after the award date," says Kasznik. Rushing bad news about lackluster earnings just before an option award can push the stock price (and exercise price of the option) down, thereby allowing greater profit for the executive when he exercises his option some time later — assuming, of course, that stock prices continue to rise.
Managing the market's expectation for the stock downward can result in significant CEO financial gains. The authors calculated that for every $1 reduction in exercise price, the value of each option increases by approximately 68 cents. On an average CEO grant of 65,000 options, a single dollar reduction in exercise price would reap a $44,200 gain. The researchers found that the estimated gain was particularly high among chief executives whose fixed award dates preceded earnings announcements, providing them with greater incentives to manage their voluntary disclosures.
The study is relevant to the huge growth in CEO compensation over the last two decades, much of it in the form of skyrocketing stock options. The percentage of chief executives receiving new stock option grants increased from 30 percent in 1980 to nearly 70 percent in 1994, report the authors. While non-option compensation, such as salary and bonus, nearly doubled to an average $1.3 million over that period, the average estimated value of annual option awards grew six times, from $200,000 to $1.2 million.
Aboody and Kasznik's research was made possible by new Securities and Exchange Commission disclosure rules issued in 1992. They require more details about top executives' pay be made public than had been available before. Proxy statements now report an option's duration and expiration date, which enabled the researchers to determine the exact date of the stock option award, a key factor in their analysis. Nearly all stock option awards are granted with a fixed exercise price that equals the stock price on the date of the award. Many companies also have a regular schedule for awarding options to their top managers. That feature allowed the researchers to test their hunch that CEOs manage their disclosures, such as positive or negative product and earnings forecasts. They screened out cases in which top managers might have influenced the timing of the awards themselves.
Playing with disclosure dates does not seem to expose executives to the same level of legal liability as other forms of insider trading, says Kasznik. After all, a CEO may be able to manipulate an option price lower, but it doesn't create a profit until the option is exercised some time later. There are no guarantees: The CEO might never profit if the stock price goes south before the option can be cashed out. "It's a gray area," says Kasznik.
One way to minimize CEOs' incentive to manipulate disclosures in this way is to set award dates after quarterly announcements, says Kasznik. For now, the study sheds light on corporate disclosure decisions, particularly related to voluntary disclosures of bad news, and may also be of value to accountants and compensation consultants who advise senior executives on how to make the most of their compensation packages.